1) Tell me how you would do a DCF

2) What is WACC
3) Would you prefer a firm with all equity and no debt or a firm with some debt and the rest as
equity
4) Tell me about your past work experience
5) How do the different statements link to each other

value company through multiples or dcf

FCF = ebit(1-t) + deprec - capex - increase in wc
get terminal value similar to a growing perpetuity
discount fcfs and the terminal value using the discount rate you get through the capital asset
pricing model which is Rd = risk free return + beta(return of market - risk free return)
wacc = weighted average cost of capital
wacc = e/d+e times cost of equity + d/d+e times cost of debt times (1-tax rate)
to put in very simple terms

In a nutshell, FCF is the leftover cash that flows to the debt and equity holders after the expenditures for
growing the business (e.g. CAPEX). So say if you invested in company A, the value that accrues to you as
an investor would be these FCFs in the future. But since these are cashflows in the future, you need to
discount them because money today is worth more than the money tomorrow. You discount them using the
WACC. The WACC is basically the debt holder's and equity holder's (you included) required return, given the
perceived RISK of the investment. It's essentially saying, if $110 will go to you a year from now, how much
would you invest in to get a 10% return? You would put in a $100. The discounting formula is just a way to
"back out" to the amount that you're investing based on your required rate of return.

she asked about Beta, what it meant, how to get it, CAPM model application...asked if I would want
company w/ debt + equity or no debt...asked which company would have higher Beta (all equity)
Valuation

What are the three main valuation methodologies?

The three main valuation methodologies are (1) comparable company analysis, (2)
precedent transaction analysis and (3) discounted cashflow (”DCF”) analysis.

Of the three main valuation methodologies, which ones are likely to result
in higher/lower value?

Firstly, the Precedent Transactions methodology is likely to give a higher valuation than
the Comparable Company methodology. This is because when companies are purchased,
the target’s shareholders are typically paid a price that is higher than the target’s current
stock price. Technically speaking, the purchase price includes a “control premium.”
Valuing companies based on M&A transactions (a control based valuation methodology)
will include this control premium and therefore likely result in a higher valuation than a
public market valuation (minority interest based valuation methodology).

The Discounted Cash Flow (DCF) analysis will also likely result in a higher valuation
than the Comparable Company analysis because DCF is also a control based
methodology and because most projections tend to be pretty optimistic. Whether DCF
will be higher than Precedent Transactions is debatable but is fair to say that DCF
valuations tend to be more variable because the DCF is so sensitive to a multitude of
inputs or assumptions.

How do you use the three main valuation methodologies to conclude value?

The best way to answer this question is to say that you calculate a valuation range for
each of the three methodologies and then “triangulate” the three ranges to conclude a
valuation range for the company or asset being valued. You may also put more weight on
one or two of the methodologies if you think that they give you a more accurate
valuation. For example, if you have good comps and good precedent transactions but
have little faith in your projections, then you will likely rely more on the Comparable
Company and Precedent Transaction analyses than on your DCF.

What are some other possible valuation methodologies in addition to the

main three?

Other valuation methodologies include leverage buyout (LBO) analysis, replacement

value and liquidation value.

What are some common valuation metrics?

Probably the most common valuation metric used in banking is Enterprise Value
(EV)/EBITDA. Some others include EV/Sales, EV/EBIT, Price to Earnings (P/E)
and Price to Book Value (P/BV).

Why can’t you use EV/Earnings or Price/EBITDA as valuation metrics?

Enterprise Value (EV) equals the value of the operations of the company attributable to
all providers of capital. That is to say, because EV incorporates all of both debt and
equity, it is NOT dependant on the choice of capital structure (i.e. the percentage of debt
and equity). If we use EV in the numerator of our valuation metric, to be consistent
(apples to apples) we must use an operating or capital structure neutral (unlevered) metric
in the denominator, such as Sales, EBIT or EBITDA. These such metrics are also not
dependant on capital structure because they do not include interest expense. Operating
metrics such as earnings do include interest and so are considered leveraged or capital
structure dependant metrics. Therefore EV/Earnings is an apples to oranges comparison
and is considered inconsistent. Similarly Price/EBITDA is inconsistent because Price (or
equity value) is dependant on capital structure (levered) while EBITDA is unlevered.
Again, apples to oranges. Price/Earnings is fine (apples to apples) because they are both
levered.

Enterprise Value and Equity Value

What is the difference between enterprise value and equity value?

Enterprise Value represents the value of the operations of a company attributable to all
providers of capital. Equity Value is one of the components of Enterprise Value and
represents only the proportion of value attributable to shareholders.

What is the formula for Enterprise Value?

The formula for enterprise value is: market value of equity (MVE) + debt + preferred
stock + minority interest – cash.

How do you calculate the market value of equity?

A company’s market value of equity (MVE) equals its share price multiplied by the
number of fully diluted shares outstanding.

What is the difference between basic shares and fully diluted shares?

Basic shares represent the number of common shares that are outstanding today (or as of
the reporting date). Fully diluted shares equals basic shares plus the potentially dilutive
effect from any outstanding stock options, warrants, convertible preferred stock or
convertible debt. In calculating a company’s market value of equity (MVE) we always
want to use diluted shares. Implicitly the market also uses diluted shares to value a
company’s stock.
How do you calculate fully diluted shares?

To calculate fully diluted shares, we need to add the basic number of shares (found on the
cover of a company’s most recent 10Q or 10K) and the dilutive effect of employee stock
options. To calculate the dilutive effect of options we typically use the Treasury Stock
Method. The options information can be found in the company’s latest 10K. Note that if
the company has other potentially dilutive securities (e.g. convertible preferred stock or
convertible debt) we may need to account for those as well in our fully diluted share
count.

How do we use the Treasury Stock Method to calculate diluted shares?

To use the Treasury Stock Method, we first need a tally of the company’s issued stock
options and weighted average exercise prices. We get this information from the
company’s most recent 10K. If our calculation will be used for a control based valuation
methodology (i.e. precedent transactions) or M&A analysis, we will use all of the options
outstanding. If our calculation is for a minority interest based valuation methodology
(i.e. comparable companies) we will use only options exercisable. Note that options
exercisable are options that have vested while options outstanding takes into account both
options that have vested and that have not yet vested.

Once we have this option information, we subtract the exercise price of the options from
the current share price (or per share purchase price for an M&A analysis), divide by the
share price (or purchase price) and multiply by the number of shares outstanding. We
repeat this calculation for each subset of options reported in the 10K (usually companies
will report several line items of options categorized by exercise price). Aggregating the
calculations gives us the amount of diluted shares. If the exercise price of an option is
greater than the share price (or purchase price) then the options are out-of-the-money and
have no dilutive effect.

The concept of the treasury stock method is that when employees exercise options, the
company has to issue the appropriate number of new shares but also receives the exercise
price of the options in cash. Implicitly, the company can “use” this cash to offset the cost
of issuing new shares. This is why the diluted effect of exercising one option is not one
full share of dilution, but a fraction of a share equal to what the company does NOT
receive in cash divided by the share price.

Why do you subtract cash in the enterprise value formula?

Cash gets subtracted when calculating Enterprise Value because (1) cash is considered a
non-operating asset AND (2) cash is already implicitly accounted for within equity
value. Note that when we subtract cash, to be precise, we should say excess cash.
However, we will typically make the assumption that a company’s cash balance
(including cash equivalents such as marketable securities or short-term investments)
equals excess cash.
What is Minority Interest and why do we add it in the Enterprise Value
formula?

When a company owns more than 50% of another company, U.S. accounting rules state
that the parent company has to consolidate its books. In other words, the parent company
reflects 100% of the assets and liabilities and 100% of financial performance (revenue,
costs, profits, etc.) of the majority-owned subsidiary (the “sub”) on its own financial
statements. But since the parent company does not 100% of the sub, the parent company
will have a line item called minority interest on its income statement reflecting the
portion of the sub’s net income that the parent is not entitled to (the percentage that it
does not own). The parent company’s balance sheet will also contain a line item called
minority interest which reflects the percentage of the sub’s book value of equity that the
parent does NOT own. It is the balance sheet minority interest figure that we add in the
Enterprise Value formula.

Now, keep in mind that the main use for Enterprise Value is to create valuation
ratios/metrics (e.g. EV/Sales, EV/EBITDA, etc.) When we take, say, sales or EBITDA
from the parent company’s financial statements, these figures due to the accounting
consolidation, will contain 100% of the sub’s sales or EBITDA, even though the parent
does not own 100%. In order to counteract this, we must add to Enterprise Value, the
value of the sub that the parent company does not own (the minority interest). By doing
this, both the numerator and denominator of our valuation metric account for 100% of the
sub, and we have a consistent (apples to apples) metric.

One might ask, instead of adding minority interest to Enterprise Value, why don’t we just
subtract the portion of sales or EBITDA that the parent does NOT own. In theory, this
would indeed work and may in fact be more accurate. However, typically we do not have
enough information about the sub to do such an adjustment (minority owned subs are
rarely, if ever, public companies). Moreover, even if we had the financial information of
the sub, this method is clearly more time consuming.

Discounted Cash Flow (DCF)

Walk me through a Discounted Cash Flow (”DCF”) analysis…

In order to do a DCF analysis, first we need to project free cash flow for a period of time
(say, five years). Free cash flow equals EBIT less taxes plus D&A less capital
expenditures less the change in working capital. Note that this measure of free cash flow
is unlevered or debt-free. This is because it does not include interest and so is
independent of debt and capital structure.

Next we need a way to predict the value of the company/assets for the years beyond the
projection period (5 years). This is known as the Terminal Value. We can use one of two
methods for calculating terminal value, either the Gordon Growth (also called
Perpetuity Growth) method or the Terminal Multiple method. To use the Gordon Growth
method, we must choose an appropriate rate by which the company can grow forever.
This growth rate should be modest, for example, average long-term expected GDP
growth or inflation. To calculate terminal value we multiply the last year’s free cash flow
(year 5) by 1 plus the chosen growth rate, and then divide by the discount rate less growth
rate.

The second method, the Terminal Multiple method, is the one that is more often used in
banking. Here we take an operating metric for the last projected period (year 5) and
multiply it by an appropriate valuation multiple. This most common metric to use is
EBITDA. We typically select the appropriate EBITDA multiple by taking what we
concluded for our comparable company analysis on a last twelve months (LTM) basis.

Now that we have our projections of free cash flows and terminal value, we need to
“present value” these at the appropriate discount rate, also known as weighted average
cost of capital (WACC). For discussion of calculating the WACC, please read the next
topic. Finally, summing up the present value of the projected cash flows and the present
value of the terminal value gives us the DCF value. Note that because we used unlevered
cash flows and WACC as our discount rate, the DCF value is a representation of
Enterprise Value, not Equity Value.

What is WACC and how do you calculate it?

The WACC (Weighted Average Cost of Capital) is the discount rate used in a Discounted
Cash Flow (DCF) analysis to present value projected free cash flows and terminal value.
Conceptually, the WACC represents the blended opportunity cost to lenders and investors
of a company or set of assets with a similar risk profile. The WACC reflects the cost of
each type of capital (debt (”D”), equity (”E”) and preferred stock (”P”)) weighted by the
respective percentage of each type of capital assumed for the company’s optimal capital
structure. Specifically the formula for WACC is: Cost of Equity (Ke) times % of Equity
(E/E+D+P) + Cost of Debt (Kd) times % of Debt (D/E+D+P) times (1-tax rate) + Cost of
Preferred (Kp) times % of Preferred (P/E+D+P).

To estimate the cost of equity, we will typically use the Capital Asset Pricing Model
(”CAPM”) (see the following topic). To estimate the cost of debt, we can analyze the
interest rates/yields on debt issued by similar companies. Similar to the cost of debt,
estimating the cost of preferred requires us to analyze the dividend yields on preferred
stock issued by similar companies.

How do you calculate the cost of equity?

To calculate a company’s cost of equity, we typically use the Capital Asset Pricing Model
(CAPM). The CAPM formula states the cost of equity equals the risk free rate plus the
multiplication of Beta times the equity risk premium. The risk free rate (for a U.S.
company) is generally considered to be the yield on a 10 or 20 year U.S. Treasury Bond.
Beta (See the following question on Beta) should be levered and represents the riskiness
(equivalently, expected return) of the company’s equity relative to the overall equity
markets. The equity risk premium is the amount that stocks are expected to outperform
the risk free rate over the long-term. Prior to the credit crises, most banks tend to use an
equity risk premium of between 4% and 5%. However, today is assumed that the equity
risk premium is higher.

What is Beta?

Beta is a measure of the riskiness of a stock relative to the broader market (for broader
market, think S&P500, Wilshire 5000, etc). By definition the “market” has a Beta of one
(1.0). So a stock with a Beta above 1 is perceived to be more risky than the market and a
stock with a Beta of less than 1 is perceived to be less risky. For example, if the market is
expected to outperform the risk-free rate by 10%, a stock with a Beta of 1.1 will be
expected to outperform by 11% while a stock with a Beta of 0.9 will be expected
to outperform by 9%. A stock with a Beta of -1.0 would be expected to underperform the
risk-free rate by 10%. Beta is used in the capital asset pricing model (CAPM) for the
purpose of calculating a company’s cost of equity. For those few of you that remember
your statistics and like precision, Beta is calculated as the covariance between a stock’s
return and the market return divided by the variance of the market return.

When using the CAPM for purposes of calculating WACC, why do you
have to unlever and then relever Beta?

In order to use the CAPM to calculate our cost of equity, we need to estimate the
appropriate Beta. We typically get the appropriate Beta from our comparable companies
(often the mean or median Beta). However before we can use this “industry” Beta we
must first unlever the Beta of each of our comps. The Beta that we will get (say from
Bloomberg or Barra) will be a levered Beta.

Recall what Beta is: in simple terms, how risky a stock is relative to the market. Other
things being equal, stocks of companies that have debt are somewhat more risky that
stocks of companies without debt (or that have less debt). This is because even a small
amount of debt increases the risk of bankruptcy and also because any obligation to pay
interest represents funds that cannot be used for running and growing the business. In
other words, debt reduces the flexibility of management which makes owning equity in
the company more risky.

Now, in order to use the Betas of the comps to conclude an appropriate Beta for the
company we are valuing, we must first strip out the impact of debt from the comps’
Betas. This is known as unlevering Beta. After unlevering the Betas, we can now use the
appropriate “industry” Beta (e.g. the mean of the comps’ unlevered Betas) and relever it
for the appropriate capital structure of the company being valued. After relevering, we
can use the levered Beta in the CAPM formula to calculate cost of equity.

What are the formulas for unlevering and levering Beta?

Unlevered Beta = Levered Beta / (1 + ((1 – Tax Rate) x (Debt/Equity)))

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

Which is less expensive capital, debt or equity?

Debt is less expensive for two main reasons. First, interest on debt is tax deductible (i.e.
the tax shield). Second, debt is senior to equity in a firm’s capital structure. That is, in a
liquidation or bankruptcy, the debt holders get paid first before the equity holders receive
anything. Note, debt being less expensive capital is the equivalent to saying the cost of
debt is lower than the cost of equity.

Mergers and Acquisitions

Walk me through an accretion/dilution analysis…

The purpose of an accretion/dilution analysis (sometimes also referred to as a quick-and-

dirty merger analysis) is to project the impact of an acquisition to the acquiror’s Earnings
Per Share (EPS) and compare how the new EPS (”proforma EPS”) compares to what the
company’s EPS would have been had it not executed the transaction.

In order to do the accretion/dilution analysis, we need to project the combined company’s

net income (”proforma net income”) and the combined company’s new share count. The
proforma net income will be the sum of the buyer’s and target’s projected net income
plus/minus certain transaction adjustments. Such adjustments to proforma net income
(on a post-tax basis) include synergies (positive or negative), increased interest expense
(if debt is used to finance the purchase), decreased interest income (if cash is used to
finance the purchase) and any new intangible asset amortization resulting from the
transaction.

The proforma share count reflects the acquiror’s share count plus the number of shares to
be created and used to finance the purchase (in a stock deal). Dividing proforma net
income by proforma shares gives us proforma EPS which we can then compare to the
acquiror’s original EPS to see if the transaction results in an increase to EPS (accretion)
or a decline in EPS (dilution). Note also that we typically will perform this analysis
using 1-year and 2-year projected net income and also sometimes last twelve months
(LTM) proforma net income.

What factors can lead to the dilution of EPS in an acquisition?

A number of factors can cause an acquisition to be dilutive to the acquiror’s earnings per
share (EPS), including: (1) the target has negative net income, (2) the target’s
Price/Earnings ratio is greater than the acquiror’s, (3) the transaction creates a significant
amount of intangible assets that must be amortized going forward, (4) increased interest
expense due to new debt used to finance the transaction, (5) decreased interest income
due to less cash on the balance sheet if cash is used to finance the transaction and (6) low
or negative synergies.
If a company with a low P/E acquires a company with a high P/E in an all
stock deal, will the deal likely be accretive or dilutive?

Other things being equal, if the Price to Earnings ratio (P/E) of the acquiring company is
lower than the P/E of the target, then the deal will be dilutive to the acquiror’s Earnings
Per Share (EPS). This is because the acquiror has to pay more for each dollar of earnings
than the market values its own earnings. Hence, the acquiror will have to issue
proportionally more shares in the transaction. Mechanically, proforma earnings, which
equals the acquiror’s earnings plus the target’s earnings (the numerator in EPS) will
increase less than the proforma share count (the denominator), causing EPS to decline.

What is goodwill and how is it calculated?

Goodwill, a type of intangible asset, is created in an acquisition and reflects the value
(from an accounting standpoint) of a company that is not attributed to its other assets and
liabilities. Goodwill is calculated by subtracting the target’s book value (written up to
fair market value) from the equity purchase price paid for the company. This equation is
sometimes referred to as the “excess purchase price.” Accounting rules state that
goodwill no longer should be amortized each period, but must be tested once per
year for impairment. Absent impairment, goodwill can remain on a company’s balance
sheet indefinitely.

Why might one company want to acquire another company?

There are a variety of reasons why companies do acquisitions. Some common reasons
include:

• - The Buyer views the Target as undervalued.

• - The Buyer’s own organic growth has slowed or stalled and needs to grow in
other ways (via acquiring other companies) in order to satisfy the growth
expectations of Wall Street.
• - The Buyer expects the deal to result in significant synergies (see the next post
for a discussion of synergies).
• - The CEO of the Buyer wants to be CEO of a larger company, either because of
ego, legacy or because he/she will get paid more.

Explain the concept of synergies and provide some examples.

In simple terms, synergy occurs when 2 + 2 = 5. That is, when the sum of the value of
the Buyer and the Target as a combined company is greater than the two companies
valued apart. Most mergers and large acquisitions are justified by the amount of
projected synergies. There are two categories of synergies: cost synergies and revenue
synergies. Cost synergies refer to the ability to cut costs of the combined companies due
to the consolidation of operations. For example, closing one corporate headquarters,
laying off one set of management, shutting redundant stores, etc. Revenue synergies
refer to the ability to sell more products/services or raise prices due to the merger. For
example, increasing sales due to cross-marketing, co-branding, etc. The concept of
economies of scale can apply to both cost and revenue synergies.

In practice, synergies are “easier said than done.” While cost synergies are difficult to
achieve, revenue synergies are even harder. The implication is that many mergers fail to
live up to expectations and wind up destroying shareholder value rather than create it. Of
course, this last fact never finds its way into a banker’s M&A pitch.

Leveraged Buyout (LBO) Analysis

Walk me through an LBO analysis…

First, we need to make some transaction assumptions. What is the purchase price and
how will the deal be financed? With this information, we can create a table of Sources
and Uses (where Sources equals Uses). Uses reflects the amount of money required to
effectuate the transaction, including the equity purchase price, any existing debt being
refinanced and any transaction fees. The Sources tells us from where the money is
coming, including the new debt, any existing cash that will be used, as well as the equity
contributed by the private equity firm. Typically, the amount of debt is assumed based on
the state of the capital markets and other factors, and the amount of equity is the
difference between the Uses (total funding required) and all of the other sources of
funding.

The next step is to change the existing balance sheet of the company to reflect the
transaction and the new capital structure. This is known as constructing the “proforma”
balance sheet. In addition to the changes to debt and equity, intangible assets such as
goodwill and capitalized financing fees will likely be created.

The third, and typically most substantial step is to create an integrated cash flow model
for the company. In other words, to project the company’s income statement, balance
sheet and cash flow statement for a period of time (say, five years). The balance sheet
must be projected based on the newly created proforma balance sheet. Debt and interest
must be projected based on the post-transaction debt.

Once the functioning model is created, we can make assumptions about the private equity
firm’s exit from its investment. For example, a typical assumption is that the company is
sold after five years at the same implied EBITDA multiple at which the company was
purchased. Projecting a sale value for the company allows us to also calculate the value
of the private equity firm’s equity stake which we can then use to analyze its internal rate
of return (IRR). Absent dividends or additional equity infusions, the IRR equals the
average annual compounded rate at which the PE firm’s original equity investment
grows (to its value at the exit).

While the private equity firm’s IRR is usually the most important piece of information
that comes out of an LBO analysis, the analysis also has other uses. By assuming the PE
firm’s required IRR (amongst other things), we can back into a purchase price for the
company, thus using the analysis for valuation purposes. In addition, we can utilize the
LBO model to analyze the trend of credit statistics (such as the leverage ratio and interest
coverage ratio) which is especially important from a lender’s perspective.

Why do private equity firms use leverage when buying a company?

By using significant amounts of leverage (debt) to help finance the purchase price, the
private equity firm reduces the amount of money (the equity) that it must contribute to
the deal. Reducing the amount of equity contributed will result in a substantial increase
to the private equity firm’s rate of return upon exiting the investment (e.g. selling the
company five years later).

Let’s say you run an LBO analysis and the private equity firm’s return is
too low. What drivers to the model will increase the return?

Some of the key ways to increase the PE firm’s return (in theory, at least) include:

• - reduce the purchase price that the PE firm has to pay for the company
• - increase the amount of leverage (debt) in the deal
• - increase the price for which the company sells when the PE firm exits its
investment (i.e. increase the assumed exit multiple)
• - increase the company’s growth rate in order to raise operating income/cash
flow/EBITDA in the projections
decrease the company’s costs in order to raise operating income/cash
flow/EBITDA in the projections

What are some characteristics of a company that is a good LBO

candidate?

Notwithstanding the recent LBO boom where nearly all companies were considered to be
possible LBO candidates, characteristics of a good LBO target include steady cash flows,
limited business risk, limited need for ongoing investment (e.g. capital expenditures or
working capital), strong management, opportunity for cost reductions and a high asset
base (to use as debt collateral). The most important trait is steady cash flows, as the
company must have the ability to generate the cash flow required to support relatively
high interest expense.

Accounting

How does ??? impact the three financial statements?

Varieties of this question are some of the most common technical question asked in
interviews today. This type of question attempts to test your understanding of how the
three financial statements (income statement, balance sheet, cash flow statement) fit
together. The most common variation of this question is how does $10 of depreciation
affect the three financial statements (answered below). I’ve posted a few additional
examples as well.

To answer this question, take the 3 statements one at a time. My advice is to start with the
income statement. Remember to tax-affect any change in revenue or costs (usually you
will be told to assume a tax rate of 40%). Work your way down to net income. Next,
tackle the cash flow statement. The first line of the cash flow statement is net income so
start with that and work your way down to net change in cash. Last, take the balance
sheet. The first line of the balance sheet is cash so again, start with that. The balance
sheet must balance in order for your answer to be correct, which is why I recommend
doing the balance sheet last. Remember the basic balance sheet equation: Assets =
Liabilities + Shareholders’ Equity.

Don’t get too stressed when asked a question like this. Just take it slowly, one statement
at a time.

If a company incurs $10 (pretax) of depreciation expense, how does that

affect the three financial statements?

The most common version of this type of question. Note that the amount of depreciation
may be a number other than $10. To answer this question, take the three statements one
at a time.

First, the income statement: depreciation is an expense so operating income (EBIT)

declines by $10. Assuming a tax rate of 40%, net income declines by $6. Second, the
cash flow statement: net income decreased $6 and depreciation increased $10 so cash
flow from operations increased $4. Finally, the balance sheet: cumulative depreciation
increases $10 so Net PP&E decreases $10. We know from the cash flow statement that
cash increased $4. The $6 reduction of net income caused retained earnings to decrease
by $6. Note that the balance sheet is now balanced. Assets decreased $6 (PP&E -10 and
Cash +4) and shareholder’s equity decreased $6.

You may get the follow-up question: If depreciation is non-cash, explain how this
transaction caused cash to increase $4. The answer is that because of the depreciation
expense, the company had to pay the government $4 less in taxes so it increased its cash
position by $4 from what it would have been without the depreciation expense.

A company makes a $100 cash purchase of equipment on Dec. 31. How

does this impact the three statements this year and next year?

First Year: Let’s assume that the company’s fiscal year ends Dec. 31. The relevance of
the purchase date is that we will assume no depreciation the first year. Income
Statement: A purchase of equipment is considered a capital expenditure which does not
impact earnings. Further, since we are assuming no depreciation, there is no impact to
net income, thus no impact to the income statement. Cash Flow Statement: No change to
net income so no change to cash flow from operations. However we’ve got a $100
increase in capex so there is a $100 use of cash in cash flow from investing activities. No
change in cash flow from financing (since this is a cash purchase) so the net effect is a
use of cash of $100. Balance Sheet: Cash (asset) down $100 and PP&E (asset) up $100
so no net change to the left side of the balance sheet and no change to the right side. We
are balanced.

Second Year: Here let’s assume straightline depreciation over 5 years and a 40% tax
rate. Income Statement: Just like the previous question: $20 of depreciation, which
results in a $12 reduction to net income. Cash Flow Statement: Net income down $12
and depreciation up $20. No change to cash flow from investing or financing activities.
Net effect is cash up $8. Balance Sheet: Cash (asset) up $8 and PP&E (asset) down $20
so left side of balance sheet doen $12. Retained earnings (shareholders’ equity) down
$12 and again, we are balanced.

Same question as the previous but the company finances the purchase of
equipment by issuing debt rather than paying cash.

First Year: Income Statement: No depreciation and no interest expense so no change.

Cash Flow Statement: No change to net income so no change to cash flow from
operations. Just like the previous question, we’ve got a $100 increase in capex so there is
a $100 use of cash in cash flow from investing activities. Now, however, in our
cash flows from financing section, we’ve got an increase in debt of $100 (source of
cash). Net effect is no change to cash. Balance Sheet: No change to cash (asset), PP&E
(asset) up $100 and debt (liability) up $100 so we balance.

Second Year: Same depreciation and tax assumptions as previously. Let’s also assume a
10% interest rate on the debt and no debt amortization. Income Statement: Just like the
previous question: $20 of depreciation but now we also have $10 of interest expense.
Net result is a $18 reduction to net income ($30 x (1 – 40%)). Cash Flow Statement: Net
income down $18 and depreciation up $20. No change to cash flow from investing or
financing activities (if we assumed some debt amortization, we would have a use of cash
in financing activities). Net effect is cash up $2. Balance Sheet: Cash (asset) up $2 and
PP&E (asset) down $20 so left side of balance sheet down $18. Retained earnings
(shareholders’ equity) down $18 and voila, we are balanced.

Continuing with the last question, on Jan. 1 of Year 3 the equipment

breaks and is deemed worthless. The bank calls in the loan. What happens
in Year 3?

Now the company must writedown the value of the equipment down to $0. At the
beginning of Year 3, the equipment is on the books at $80 after one year’s depreciation.
Further, the company must pay back the entire loan. Income statement: The $80
writedown causes net income to decline $48. There is no further depreciation expense
and no interest expense. Cash Flow Statement: Net income down $48 but the writedown
is non-cash so add $80. Cash flow from financing decreases $100 when we pay back the
loan. Net cash is down $68. Balance Sheet: Cash (asset) down $68, PP&E (asset) down
$80, Debt (liability) down $100 and Retained Earnings (shareholders’ equity) down $48.
Left side of the balance sheet is down $148 and right side is down $148 and we’re good!